Determining Equity for an Employee Pre-Funding

I'm bringing on someone who has been contracting for me; she will now be the Lead UX/UI Designer. She is not coming on board as a co-founder, but as a full-time employee/for equity. I'm wanting to find the right balance to honor the fact that she is taking risk by giving me 160 hrs/month for $0 cash (until funding).

I’ve estimated the valuation of the my company at 3.5M. Her current contract rate is $45 (low, b/c she's transitioning into UX/UI). I used a formula of 90K/3.5M = ~2.57 (x2 as a risk multiplier for taking all equity and no pay) = 5.14%. Curious as to what people’s thoughts are.

She wanted to know what I think about a different scenario:

- She gets paid in equity pro-rated for the amount of time pre-funding (i.e., 100% if 12 months, 50% if 6 months, etc.)- She receive cash payment at discounted rate - let’s say half - after funding. The other half is paid in equity.

- The equity terms are tbd.

However, I am against splitting it as deferred cash and equity. I'm concerned it will price the equity, which I don't want to do. As such I'm thinking to stay with straight equity for now: the same way I am working and all other team members are working.

Hi Andrea,
Don't do deferred cash, not for the reason you gave, but because investors
don't want their investment going to pay off debt (personal experience). If
the dollar figure is more than 10% of the raise, it could kill your deal
before you even have one. If you do give deferred pay, make sure it's not
more than 10%.
Beyond that, you're asking her to be a ground-floor investor in your
startup. 160 hours a month is practically full-time. I'm really, really
concerned about her risk exposure. Ground floor angel investors, which
you're asking her to be, are wealthy. If she's making $45/ hour, she's not.
The ethical thing to do in this case is to reduce her risk exposure, or
treat her like a co-founder. If she's a co-founder, have her equity vest
over 4 years, and make it very substantial (25% or so). If she's not, find
a way to at least pay half of her income in cash, and the other half in
equity on the same types of terms you would actually receive at this point
from an Angel. Most likely an Angel would peg your company, due to lack of
customers/ product, at somewhere near $100,000 to $500,000, but almost
definitely not $3.5M (which is what you think you'll get after some level
of product or customers).
I hope this is helpful... and it's just my opinion.
Sincerely,
Daniel E Weisman

You are potentially going down the nightmare route of many startups. That is, releasing small parcels of equity to individuals who may not stay with you over the longer term. Funding is never a certainty, and neither is the fact that you will continue with the same project that you are currently developing.

Even if you receive funding she is unlikely to realise the value of her stock at that point. Most funders will want new cash to be used by the business and not in paying off historic debts, which is why equity dilution is the norm. It is for this reason that stock in a start-up is all about the future and not about the present.

The world is littered with useless stock certificates because the company didn't make it to a liquidity event which gave current shareholders a pay day. Stock, although taxable, is not bankable and is full of risk. It's a sign of her faith in your business and is not a promissory note. She is still working for nothing.

I'm assuming you are pre-revenue so the valuation of your business is probably highly suspect and not really a good basis for determining her rewards. For this to be fair it would need to be based on a good determination of future value plus an NPV calculation. The size of her award right now should be based on her value to the business and your desire to keep her working for you. If this is likely to be a short term gig you don't want to go down the equity route at all but opt for deferred payment. Perhaps a stock option plan to keep her involved or even a convertible bond based on sweat equity - that way she can decide to take the cash plus a 'coupon' or covert in part or whole to equity at some future date.

The amount you give away at this point should be in relation to other shareholders and her value to you in the longer term moderated by a dispassionate view of the company's likely future value. She is taking a risk in working for you for nothing, it builds her portfolio but doesn't feed her. That is a moderating factor in whatever you decide.

Most schools of thought have to do with valuation, compensation, and commitment but I've found that those "hard" considerations of an early cap table fail to really establish the value and passion of the core team. The way in which early equity is handled (not just share but cliff and vesting), speaks to less tangible values that the company is establishing.

Here are some thoughts on what to consider with regard to the stage of the company, the role of the individuals, and how much (or little) they are valued.

I want you to first ask and answer that question by warping your perspective of the term "investor" for a moment. I'm not asking you if your co-founder and employees are indeed investors, I'm asking you if they are investing their time in your venture. How do you perceive their contribution?

All that said, if you want a more practical and tangible way of addressing the issue, along the lines of Tomas' suggestion of Slicing Pie, consider using the Startup Equity Calculator.

xx shares in exchange for an hour's work doesn't price the equity unless there's a price associated with the work. It's not any different if you trade y shares + $10 for an hour's work. That's especially true if the two schemes are time-separated, as the value of equity is constantly changing.

That said, your posting goes a long way toward establishing an equity price, exactly what you say you don't want to do.

A bridge-loan / convertible debt that converts to equity would solve keeping the estimation of your company open. And you could write it less abstractly: instead of 50% if 6 months, she gets paid via the loan for however much work she does at whatever rate you agree to, and do the math after you have a real valuation. You could even let her decide whether to invest or get cash out when the investment happens.

Without knowing any details, working for just equity for 12 months seems like she is absorbing a lot of founder-risk without quite the reward. If you do get funding, does that mean your work right now gets valued such that you are a millionaire, and she made 2x$45/hour, for doing work at the same level of current risk? If I was advising her, I'd push for Moyer's Slicing Pie model that seems to me much more balanced and especially more clear. If you do do a bridge loan, instead of 2x her rate, you might consider the risks during the period before you are funded as a multiplier to her base rate, and a second (probably smaller) bonus once you have an investor that encourages her to keep her money invested instead of taking cash (these seem like separate issues?).